Sale-Leaseback Transactions: a Financing Alternative for Middle Market Companies

19 Sale-Leaseback Transactions: A Financing Alternative for Middle Market Companies

Terrel G. Bressler – [email protected] Tyler C. Willibrand – [email protected] – Net Lease Holdings, LLC

The last few years have been a very difficult time for middle While banks are beginning to become more aggressive in market businesses. The general U.S. economic situation has pursuing new lending opportunities, bank credit is relatively affected many companies’ ability to generate revenues and run expensive and more conservatively structured than prior to the their business operations. During the height of the recession, recession. Furthermore, lower middle market companies, typically most capital markets were “locked up” making it difficult and in companies with less than $25 million in revenues, still struggle to some cases impossible for middle market companies to attract find any bank financing at reasonable interest rates and terms. bank financing to run and grow their businesses. Once the economy began to improve and the recession subsided, bank The mezzanine funds have tried to bridge part of the gap in credit and other sources of capital became more available. As financing demand but at a significant cost. Mezzanine funds the economic recovery continues to build momentum, access to typically require an 18% to 22% all-in return which is comprised capital is generally improving. of a relatively high interest rate of 11% to 13% and warrants for equity to make up the additional return. While this type of capital can be useful if it really a very expensive part of any $200 company’s capital structure. $180 $160 A company’s investment in real estate and buildings are often $140 overlooked as possible value in financing transactions. Many $120 times the corporate real estate is underutilized as a financing source and is financed with a simple mortgage. An alternative to $100 a mortgage financing that better utilizes a company’s real estate $80 is the sale-leaseback. $60 $40 $20 $0 2005 2006 2007 2008 2009 2010

Middle Market Loan Issuance

Source: Reuters Loan Pricing Corporation/DealScan.

©2011 XX ©2011 19 What is a Sale-Leaseback? n n n Greater Value to the Real Estate Unlike a mortgage, a sale-leaseback can often be structured to Most companies are not in the business of owning real estate but finance up to 100% of the appraised value of the company’s need the utility of land and buildings to produce their products land and building. As a result, a sale-leaseback more efficiently or services. A sale-leaseback enables a company to reduce its uses the company’s investment in the real estate asset as a investment in these non-core business assets (the land & building) financing tool. and liberate the cash in exchange for executing a lease and paying rent. In a sense, a sale-leaseback separates the “asset value” from No Financial Covenants the “asset’s utility value” in a company’s real estate investment. Because a sale-leaseback is not technically a financing instrument A real estate sale-leaseback is a transaction in which the it does not have any covenants on the company. owner-occupant sells the land and building used in its business operations to a special purpose investor and then simultaneously leases the property back from the investor on lease terms agreed Typical Covenants to concurrent with the real estate sale transaction. Typically, this Loans (Senior Debt) Leases (Real Estate) will be a long-term investment for the special purpose investor (1) Debt Service Coverage Ratio > 1.25x Not Applicable (“NA”) so the seller is able to negotiate directly with the investor a (2) Monthly financial reporting requirements NA mutually agreeable and clear set of lease terms. Sale-leasebacks (3) Liquidity or asset turnover ratios NA have become more popular in recent years as an alternative to (4) Minimum net worth requirements NA Terrel G. Bressler – [email protected] mezzanine financing so companies can avoid the high mezzanine (5) Borrowing base limits including: NA Tyler C. Willibrand – [email protected] – interest rates and dilution (ownership) requirements typically found 80% on A/R less than 90 days NA Net Lease Holdings, LLC in these types of debt structures. 50% on marketable inventory NA Benefits: n n n Fewer covenants provide a company with greater control over its In the right set of circumstances, a sale-leaseback transaction can own business and operations. have a number of benefits to the middle market company that is the real estate seller. Attractive Implied Financing Rates

Set Your Own Lease Terms A sale-leaseback has an implicit financing rate, (“cap rate”) imbedded in the future rent payments. Although the sale-leaseback Because the seller is also the lessee, the seller has significant cap rates are frequently slightly more than similar mortgage bargaining power in structuring the property lease. In addition rates, a sale-leaseback provides cash proceeds for up to 100% to realizing their investment in the real estate, the lessee has the of the appraised value of the property versus the 70% to 80% opportunity to negotiate an acceptable lease agreement with the of appraised value under a typical mortgage. A sale-leaseback investor acquiring the property. Typical leases run 10 to 15 years. investor has only the real estate as collateral and a relationship The seller, now the tenant, can also negotiate extension options with the seller through the lease agreement. As a result, the sale- after the lease expiration, and can also include terms for early leaseback is slightly more expensive than senior financing and less lease termination if the tenant sees a need for more flexibility. expensive than mezzanine financing. Retain Control of Real Estate Typical Sale-Leaseback Applications n n n Most sale-leasebacks are structured as triple-net leases, so the tenant will be responsible for the taxes, insurance, and common Senior or Mezzanine Debt Alternative area maintenance. A long-term, ‘hands-off’ lease from the investor As described earlier, typical mezzanine financing has an all-in cost provides the tenant similar control over the property as was the of between 18% and 22%. These mezzanine lenders will often case when the tenant owned the property. The tenant can work include PIK [Payable in Kind] interest and equity ownership as part with the special purpose investor and include options that will of their total return structure. The implied financing rate, Cap Rate, provide for future expansion and sublease of the property. of a sale-leaseback is generally hundreds of basis points lower than mezzanine capital and does not require equity ownership from Tax Savings the selling entity. The proceeds from a sale-leaseback transaction Generally, lessees that are engaged in a lease are able to write can be used to refinance the mezzanine portion of the capital off their total lease payment as an expense for tax purposes. As structure or as an alternative, if there is no mezzanine to replace property owners, the interest expense and depreciation were the the company’s senior debt. In both instances the company’s only tax deductions available. As a result, a sale-leaseback may balance sheets ratios will improve substantially. have a greater tax advantage.

Asset-Based (Senior) Lender ¾ Fully Secured by Tangible Assets ¾ Examples: Revolver, Real Estate Mortgages, Asset-Based (Senior) Lender or Equipment Loans

Cash Flow (Senior) Lender ¾ Mostly Secured by Tangible Assets ¾ Based on a Multiple of EBITDA

Mezzanine Lender CASH FLOW (Senior) Lender ¾ Unsecured ¾ Rates 3-5 Years ago: 12% + PIK ¾ Current Rates: 16-18% + Warrants ¾ 5 year loan terms are expiring and refinancing alternatives are needed

REAL ESTATE MEZZANINE Lender SALE-LEASEBACK

Capital for Growth in the reorganization, then in these circumstances these special investors can make rapid investment decisions often within 45 A sale-leaseback can be used to free up cash to grow a business days, if the due diligence materials are readily available. through acquisition or acquire additional facilities, technology, and equipment. With the tightening of the credit markets, many Packaging Business for Sale businesses do not have access to as much credit as they need to achieve their growth objectives; many are too close to their It is well known that most private equity groups are not in the borrowing limit to consider expansion or make an acquisition of business of owning and managing real estate. Often a savvy a competitor. Sale-leasebacks can be used as an off balance business owner who is contemplating selling his company sheet financing structure that gives the seller the opportunity to can benefit by taking the real estate out of the company sales turn a non-earning asset into growth capital. The company can transaction and, by doing so, maximize the value of the real estate then save the available bank financing for acquisitions and growth and increase the overall gross sale proceeds. opportunities in the future. The sale-leaseback proceeds could If the real estate is left in the transaction the full value is seldom also be used for other corporate purchases like the buyout of a realized, as the EBITDA multiple often does not value the shareholder or a special cash distribution to all the shareholders. company’s real estate at its true fair market value. Sale-leaseback The absence of covenants in sale-leasebacks provides business investors will typically make their offer price based on an appraisal, owners with significant discretion on what is the best use of their extensive real estate market study, and a review of comparable company’s cash. market lease rates. The seller can complete a sale-leaseback Corporate Restructuring/Exit Financing and negotiate a long-term lease and pull out the real estate sale proceeds or repay corporate debt before the sale of the business. Businesses that are struggling for liquidity to pay creditors or are considering a bankruptcy might look to a sale-leaseback for The example on the following page shows how a sale-leaseback capital. Depending on the value of the company’s real estate, a helps to increase the proceeds to the seller in a corporate sale-leaseback can supply a considerable amount of liquidity and sales transaction. be a quick initial step to begin a reorganization process. As shown, the rent expense will slightly lessen the EBITDA, Sale-leaseback investors can work to meet tight time frames. therefore lessening the price of the operating entity. However, If a potential seller is able to provide good historical financial when the proper value of the real estate is recognized in a separate statements, a business plan, and projections and a description of sale and added to the proceeds of the company sale a higher the planned uses of proceeds from the sale-leaseback as its role overall price is achieved.

©2011 XX ©2011 Straightforward M&A Sale Operating Co. Value post SALE-LEASEBACK ADD REAL ESTATE PROPERTY VALUE EBITDA $ 4,000,000 ------> EBITDA $ 4,000,000 Rent Payment 600,000 ------> Rent Payment $ 600,000 EBITDA (Net of Rent) $ 3,400,000 CapRate paid on Rent 10% Equivalent Multiple paid on Rent 10.0x EBITDA Multiple 5.0x ------> EBITDA Multiple 5.0x Real Estate Purchase Price $ 6,000,000

Operating Co. Purchase Price $ 17,000,000 ------> + Operating Co. Purchase Price $ 17,000,000

Total Purchase Price $ 20,000,000 Combined Purchase Price $ 23,000,000

Amount allocated to Operating Co. 70% $ 14,000,000 Amounts allocated to Operating Co. Amount allocated to Real Estate 30% $ 6,000,000 vs. Real Estate may vary widely SELLER'S ADVANTAGE Enhancement in Total Purchase Price $ 3,000,000 Effective EBITDA Multiple 5.8x

FINANCING COMPARISON: Sale-Leaseback vs. Mezzanine Lending

SALE-LEASEBACK with NLH II Mezzanine / Subordinated Lenders Footnotes as related to Mezzanine: Cash Rental Payment 8 - 12% Cash Interest Rate 14 - 18% Range varies depending on credit quality, total debt & EBITDA size Other Costs/Fees 0% Non-Cash Interest Rate 2 - 4% Often consisting of PIK or expensive Warrants (equity substitutes)

Typical Lease Term (years) 10 to 20yrs Typical Loan Term (years) 4 to 6yrs Exposed to short-term interest rate volatility

Financial Statement Covenants NO Financial Statement Covenants YES Often includes limitations on Distributions, CAPEX & Total Debt Off-Balance Sheet to the Operating Co. YES Off-Balance Sheet to the Operating Co. NO Credit markets can "dry up" based on economic factors

The Investor Underwriting Process n n n Sale-Leaseback Benefits All sale-leaseback investors will follow a disciplined approach ¾ Greater financing value for real estate to conduct their due diligence that is similar to the due diligence ¾ No equity dilution efforts used when acquiring any real estate. Building and land ¾ Relatively quick closing appraisals, local market research, comparable lease and sale ¾ No covenants data, location, and accessibility analysis are just a few areas ¾ Friendly lease terms which will be considered during due diligence. The investor ¾ Improved balance sheet will also evaluate the tenant’s credit strength using analysis ¾ Favorable borrowing rates (cap rate in the lease) similar to lending institutions and corporate acquirers. Finally, when ¾ Potential tax savings a sale-leaseback investor considers an investment opportunity they will consider the long run marketability of the real estate once Properly structured a sale-leaseback can more efficiently use it is vacant. a company’s assets as a financing tool. It is important to work with an experienced team of attorneys, tax professionals and The size and shape of the building will also play in the functionality investment bankers to structure a deal that meets the company’s equation when underwriting the property. The investor is very specific circumstances. It is also important to find the right special interested in the alternate uses and users for the real estate when purpose investors that will provide a market price for the real the tenant vacates the property. All of these alternative use factors estate and negotiate a market lease with the seller. will affect the lease payment in the sale-leaseback transaction. Terrel G. Bressler is a Managing Director in the Investment Banking Conclusion n n n Group at Stout Risius Ross (SRR). He has originated a wide variety of M&A and capital raising assignments and has assisted numerous A sale-leaseback transaction represents another alternative middle market companies and their shareholders with acquisitions, middle market companies can use to raise capital and finance mergers, arranging debt, mezzanine and equity capital, and other future operations and growth. investment banking transactions. Mr. Bressler can be reached at +1.312.752.3359 or [email protected].

Tyler Willibrand works in acquisitions at Net Lease Holdings, LLC a real estate sale-leaseback fund based in St. Louis. Net Lease Holdings targets single-tenant real estate investments of $2 - $10 million, all over the United States. Mr. Willibrand can be reached at +1.314.991.1119 or [email protected].